The real effective exchange rate is a weighted average of the value of a country's currency relative to a basket of other major currencies, adjusted for differences in inflation. The real effective exchange rate often is used as a measure of the competitiveness of a country's exports. The real effective exchange rate is best understood by examining how it is different from other kinds of exchange rates.
The most fundamental exchange rate, often called the Foreign Exchange Rate, is the amount of one nation's money that can be obtained in exchange for a unit of another nation's money. Being able to convert one currency into another through a foreign exchange rate is what makes international trade possible. As with most issues in macroeconomics, it is common to adjust variables for the effects of inflation, and doing so with the foreign exchange rate yields the real exchange rate.
The real exchange rate is equal to the nominal foreign exchange rate adjusted for the difference in inflation between the two countries involved. This is determined by multiplying the foreign exchange rate by the ratio of the domestic price level to the foreign price level. The real exchange rate takes into account changes in the purchasing power of each currency because of inflation.
In the real world, countries do not have only one trading partner, so although individual exchange rates and real exchange rates between pairs of countries can be helpful, there are times when one might prefer to know the value of a country's currency relative to all of its trading partners. The effective exchange rate provides that information by weighting a country's exchange rate against an average of other currencies. The weight assigned to each currency usually, but not always, is determined by trade volume, with the most important trading partners receiving a higher weight.
The real effective exchange rate adjusts the nominal foreign exchange rate in both of these ways: accounting for a world where countries have more than one trading partner and adjusting for inflation. Calculating the real effective exchange rate begins by taking a country's nominal exchange rate with each trading partner and multiplying each by the ratio of domestic to foreign price levels, resulting in a collection of real exchange rates. Then, a weighted average of real exchange rates is calculated using the annual value of trade with each respective country or region as the weight. It usually is then converted to an index using a base period.
